Russian stocks represent classic value trap

Ivan Martchev is an investment specialist with institutional money manager
Navellier and Associates.
Previously, Ivan served as editorial director at
InvestorPlace Media. Ivan was
editor of Louis Rukeyser's Mutual Funds and associate editor of Personal
Finance. Ivan is also co-author of
The
Silk Road to Riches (Financial Times Press).

Some investors may wonder where the investing angle is in this Ukrainian conflict, whose developments often find their way into this column. I often write about macroeconomics and interest-rate trends that greatly affect all investments. In this case we have a major geopolitical crisis that does the same.

The Ukrainian crisis moves the price of oil, which is the most important commodity traded on world markets, whose price spikes have been known to cause recessions and create or wipe out fortunes. The Ukrainian situation also affects emerging market bonds, particularly those of Ukraine and Russia. It also affects the trade picture in Europe. With Russia having the EU as its largest trading partner, it is no wonder that the Europeans are reluctant to impose strict sanctions as they would be shooting themselves in the foot at a time when the European economy is weak.

I never bought the theatrical withdrawal of Russian troops from the Ukrainian border. I am of the opinion that the Russians feel their national interests were attacked by the substantive foreign interference in the toppling of Ukraine's former President. Ukraine represents the ultimate Gazprom
OGZPY, -0.47%
chokehold as it controls the pipelines that transport 55% of Gazprom's European natural gas exports.

There is also the unhappy Russian minority in Eastern Ukraine and the easternmost part of Moldova who felt repressed for many years and would like nothing more than to join the Russian Federation. The Russian government knows this and is using the present situation to further its multiple political goals.

I don't follow this crisis to identify who is right and wrong, but I am interested in how it affects financial markets. My reading of the situation has been that the conflict was intensifying all along as the casualty numbers started to accelerate and the number of downed aircraft began to notably increase. The Ukrainian bond market, and the Russian financial markets for that matter, took the withdrawal of Russian troops from the Ukrainian border as if Russia had decided to let it go, and it was only a matter of time before the Ukrainian army was going to wipe the rebels out.

This is evident from the action of Ukrainian credit default swaps which had been suffering a massive inversion in April and May, when the one-year CDS contract was trading at about double the price of the five-year CDS contract — in normal times it is usually the opposite, as the chances of default normally should be higher over a much longer period. Under this CDS inversion, investors felt that over one year, Ukraine had a higher chance of default than over five years.

In June, the CDS inversion began to close, and this week we have one- and five-year Ukrainian CDS almost at parity. I think this is absurd. I think the markets misread the withdrawal of Russian forces as a sign that the worst was over. One reason the Russians withdrew, in my opinion, was to bait the Ukrainian military into attacking the rebels so the situation on the ground would become so hopeless that they could show the world they had no choice but to intervene. We are close to such a point.

All three sides to this conflict-the Ukrainian military, the rebels, and their Russian backers say it wasn't them who shot down Malaysia Airlines flight MH17. There are tapes of conversations with traffic controllers in Kiev that have been seized by security services that should shed some light on why this plane was flying at 33,000 feet when airspace up to 32,000 feet was restricted by the Ukrainian aviation authority. Then there are the black boxes that have been delivered to the Malaysian authorities.

I don't believe the spin that comes from all sides as the first casualty of war has historically always been the truth. The YouTube "smoking gun" of rebels talking about the downed plane intercepted by Ukrainian security services is impossible to authenticate as those are just two voices speaking with native Russian accents. A large part of Ukraine doesn't even speak Ukrainian, and Russian speakers are plentiful on the Ukrainian government side. This latest "smoking gun" doesn't size up well with authenticated YouTube leaks of a call between EU foreign affairs chief Catherine Ashton and Estonian foreign minister Urmas Paet, or that of Turkish PM Erdogan talking about finding pretexts to invade Syria. Those are real leaks.

It looks to me like this conflict is about to escalate and that the false hope exhibited by Ukrainian CDS prices and, until recently, Russian stocks, is about to get priced out of those markets.

Russian dividends in serious danger

It is quite rare for a benchmark index to yield 4.25%. Years ago, the S&P 500
SPX, +0.01%
dividend yield got as high as 6%, but that was at a time of high interest rates and high rates of inflation. Today, the Russian market is the perfect example of a value trap with its juicy dividends and its depressed book values.

Not only does the MSCI Russia index yield 4.25%, but it sports an index average forward P/E of 3.89 and a price to book of 0.71. There is only one other time when I have seen this same index have a P/E in single-digit territory below its dividend yield and that was in November 2008. Then, the S&P 500 touched 741 while now it is close to 2000. This time, the geopolitical situation is clearly adding to that index compression. Curiously, before the Malaysian airliner incident, the Russian stock market had made a fresh post-Crimean high and risen to a level higher than where it was before the Crimean situation broke out. I think this was the stock market misreading the Ukrainian situation as improving.

How low can the Russian index P/E go, and is a 4.25% yield worth chasing here?

In my view, the simple answers are (1) "nobody knows" and (2) "no." It is impossible to pick an index level where the selling will stop. If Russian troops get involved in a major way in Eastern Ukraine, I think the Crimean low will be breached. The situation of generous dividends in Russian stocks becomes one where Russia will actually face more sanctions and bigger trade disruption. Ultimately those generous dividends will likely get cut, as they did in 2008 and 2009.

There are numerous ways to express the view of where the Russian stock market is going, but the major two are the Market Vectors Russia ETFRSX, -0.81%
and the iShares MSCI Russia Capped IndexERUS, -0.51%
There are also the leveraged ETFs which make for good short-term trading vehicles-read days, not weeks, which most buy-and-hold investors should stay away from.

The daily 3X compounding works miracles if the market moves in your favor and results in horror stories if the market moves against you. The worst example is the Direxion Russia Bull 3X Shares
RUSL, -2.15%
which after a sharp selloff in the summer of 2011 related to the euro-zone crisis has never managed to come back and is increasingly diverging from an unleveraged Russian ETF like the RSX.

Ivan Martchev is an investment specialist with institutional money manager Navellier and Associates. The opinions expressed are his own.Navellier and Associate s holds positions in Gazpromfor some of its clients.This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser before making any decision to buy or sell the aforementioned securities. Investing in non-U.S. securities including ADRs involves significant risks, such as fluctuation of exchange rates, that may have adverse effects on the value of the security. Securities of some foreign companies may be less liquid and prices more volatile. Information regarding securities of non-U.S. issuers may be limited.

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